Many employers that offer a traditional pension plan may also have a 401(k) or equivalent plan.
But if you had to pick between one or the other, which should you take?
In that case, the real question may be:
"Should I not participate in the 401(k) plan, just rely on the pension?"
How 401(k) Plans Work
A 401(k) plan is an employer-sponsored retirement account.
With every paycheck, you can elect to shift a portion of your earnings as contributions to your 401(k). You can invest this money into the investment options available through your 401(k) plan administrator.
The best part:
Usually, your company will offer to match a small portion of your contribution.
That is, you get free money.
For example, let's say you earn $100,000, and you make the maximum contribution to the plan.
Your employer will match 50% of the first 6%, which will be $3,000. That will give you a total contribution $22,000 for 2019.
With a traditional 401(k), your contributions are tax-deductible, while your earnings are taxed upon withdrawal.
With a Roth 401(k), your contributions are not tax-deductible, while your earnings are tax-free
Traditional 401(k) vs. Roth 401(k)
|Traditional 401(k)||Roth IRA 401(k)|
|Contributions are tax-deductible.||Contributions are not tax-deductible.|
|Pay taxes upon withdrawal.||Earnings can be withdrawn tax-free and without penalties if the funds were in the Roth 401(k) for 5 years and you've reached age 59 1/2.|
|Required minimum distributions (RMDs) are required starting at age 70 1/2.||Required minimum distributions (RMDs) are required starting at age 70 1/2.|
For 2018, you can contribute up to $18,500, for $24,500 if you are 50 or older. For 2019, the base contribution rises to $19,000, or $25,000 if you’re 50 or older.
One of the benefits of 401(k) plans is that you generally have at least some control over how the money is invested.
Exactly how much control you'll have will depend on the type of plan.
For example, some very limited plans give you a choice of only a few mutual funds or exchange traded funds.
Your only flexibility will be which one funds you invest in, and at what percent.
You can begin making withdrawals at age 59 ½.
But if you make withdrawals before that age, you'll pay ordinary income tax, plus a 10% early withdrawal penalty.
How Pensions Work
Traditional pensions are what is known as defined benefit plans.
They’re so named because the amount of the benefit you’ll receive at retirement is specifically provided.
It's based on a number of factors, including your income and the number of years of service.
Contributions to the plan are made by the employer only, and you may never know exactly how much is contributed unless you get a year-end statement.
The plan is also fully managed by your employer.
For the most part:
A pension will be invisible until you reach retirement.
Pension plans come with many different options.
Some plans may enable you to make voluntary contributions. You may also have a choice as to how to take distribution from the plan.
For example, you may have the option to either take a lump sum, or a monthly benefit.
In most cases, if you opt for a monthly benefit, you'll receive them for the rest of your life.
You normally have to work a minimum number of years to get the maximum benefit.
That might be something like 30 years or more.
But many plans provide for a payout should your employment end, though you will normally need to be working a certain number of years to receive the funds.
That might be five years, 10 years, or some other number defined in the plan.
Many plans also have survivor benefits. If you die, the benefits can transfer over to your spouse or other named beneficiary.
The Case for 401(k) Plans
401(k) plans have several benefits over pensions.
Any contributions you make to the plan are yours. If you leave your job, you can take the plan with you.
Employer matching contributions become yours once you satisfy vesting requirements. (IRS vesting rules call for vesting within two to six years).
With many plans, you can choose how the funds are invested.
The contributions you can make to a 401(k) may be (much) larger than employer pension contributions.
When you leave an employer, you can leave the funds in the plan, roll them over to a new employer 401(k), or move them into a self-directed IRA account.
Also, get to choose the tax benefit based on the type of the 401(k) you prefer -- tax-deductible contributions vs. tax-free earnings.
You can access your funds well before traditional retirement, which may make early retirement possible (though you will have to pay the 10% penalty).
Many 401(k) plans have loan provisions. You may be able to borrow as much as $50,000, up to 50% of your vested balance.
The Case for Pension Plans
Pensions have several benefits over 401(k) plans. Those include:
No work needed
You don’t have to make contributions to the plan.
You’ll have no responsibility for managing the plan.
You won’t have to worry about managing your plan once you retire.
Pension benefits are not dependent on investment performance, but on the benefit formula described in the plan.
Certain government pensions can pay monthly retirement benefits that are very close to your highest salary from the job.
Many government plans and some corporate pensions also provide employer-sponsored health insurance at retirement.
Your pension benefit is guaranteed by your employer, which is especially strong if you work for the government.
Your retirement benefit may transfer to your spouse or other beneficiaries at your death.
What Could Go Wrong with a 401(k)?
As strong as the benefits of both plans are, they also have some weak spots.
Let’s start with the 401(k) plan.
Despite your best efforts, the size of your plan at retirement, or the amount of your monthly withdrawals at retirement are not guaranteed.
You may not make good investment choices, resulting in poor investment returns. However, you can often choose to hold your plan through a managed option to do it for you.
A stock market crash or a prolonged bear market could wipe out much of your plan value.
Because you’ll be managing your plan to maximize growth, you’ll be investing heavily in stocks.
If you don’t have the risk tolerance to do that, your plan may not grow enough to allow you to retire.
If you lose your job and take a new one with an employer who has no 401(k) plan, your retirement strategy will be interrupted for a time.
The fact that you can access funds prior to retirement could cause you to draw down the account, or even empty it during a time of financial crisis or extended unemployment.
If you have an unpaid plan loan at the time you leave your job, you’ll have 60 days to repay the loan in full.
If you can’t, any amount not repaid will be converted to a taxable distribution, subject to the 10% penalty if you’re under 59 ½.
What Could Go Wrong with a Pension?
There are a few “gotchas” with pensions as well:
You must be in the plan for many years – 30 or more – to get the maximum benefit, which will commit you to your job even if you’d like to make move.
Very few jobs today offer anything close to the employment-for-life that will be needed to earn the maximum benefit.
You never actually know what’s going on with your plan, since it’s handled by your employer.
Out of your control
Employers are fully capable of mismanaging the plan.
Some corporate plans are raided by the employer for funds for unrelated purposes.
Benefits promised today may not be workable in the future (see pension crisis section below).
If your employer files for bankruptcy, the pension provisions may be reduced.
There’s mounting evidence of a pension crisis.
The Pension Benefit Guaranty Corporation (PBGC) that insures these plans is also severely under-funded.
401(k) vs. Pension: Which Should You Choose?
Fortunately, with most employers you don't have to make a choice.
Even employers that offer pensions typically offer some sort of 401(k) equivalent. Many government employers allow you to also participate in the Thrift Savings Plan (TSP).
You’re on solid ground if you can participate in both a pension and a defined contribution plan. That will give you even more income and financial resources in retirement.
And even if you’re covered by a pension but without a 401(k) option, you can still make contributions to a traditional or Roth IRA.
You can contribute up to maximum for the year. That will give you your own self-directed retirement plan to supplement your pension.
As you can see, retirement planning – like all forms of investing and preparing for the future – works best with diversification added to the mix.
That’s what you’ll have with both plans.